Federal Reserve officials are united in their determination to quell the worst inflation in forty years, but they no longer agree on how high to keep the policy interest rate to achieve their goal.

Last week, the Federal Reserve made its third rate cut of the year with an almost unanimous vote. However, officials appear to be divided into three factions regarding the future interest rate outlook.

The disagreement centers on how aggressively the Federal Reserve should lower inflation to its 2% target and at what level it needs to keep interest rates to succeed.

"There are no signs of consensus," noted FHN Chief Economist Chris Low when discussing the forecast for the benchmark federal funds rate. Most Federal Reserve officials expect this rate to fall between 3.1% and 3.9% by 2026.

The outcome of this debate is closely watched on Wall Street.

Inflation anxiety

Until a few months ago, inflation seemed to be nearing the Federal Reserve's 2% target. The central bank's preferred inflation gauge—the Personal Consumption Expenditures Index (PCE)—slowed from a 40-year peak of 7.3% in 2022 to a three-and-a-half-year low of 2.1% in September. However, as of November, this inflation indicator had risen to 2.4%.

More importantly, Federal Reserve officials believe that inflation at the end of 2025 is likely to be slightly higher than at the end of 2024. Officials have raised their forecast for 2025 to 2.5%.

"It turns out that inflation is more stubborn than many expected," said Richard Moody, chief economist at Regions Financial.

The recent uncertainty about the inflation path could keep interest rates in the USA above the level desired by Federal Reserve officials.

In fact, Federal Reserve officials last week halved their expectations for interest rate cuts in 2025 to just two.

However, due to divisions within the Federal Reserve, even the prospect of two rate cuts in 2025 cannot be guaranteed.

Rare dissent appears within the Federal Reserve.

This division is laid bare in the so-called dot plot, which reveals the thoughts of 19 Federal Reserve officials, including seven board members and 12 regional Federal Reserve presidents.

Four of these officials did not support a rate cut last week, with one, newly appointed Cleveland Federal Reserve President Harker, casting a dissenting vote.

Such dissent is quite rare at the Federal Reserve.

Harmark stated that she hopes to see more evidence indicating that price pressures are easing again. "Inflation remains stubbornly high, and the recent progress in bringing inflation back to 2% has not been even," she said in a statement.

Perhaps more surprisingly, Harmark said that she believes the Federal Reserve is nearing what is known as the neutral interest rate.

This Concept refers to the ideal level of the Federal Reserve's policy interest rate, which means it neither dangerously pushes the economy beyond its speed limit nor slams on the brakes to stifle growth.

Where is the neutral interest rate?

If the Federal Reserve is close to the neutral interest rate, it may mean that the central bank will only lower the rate by another 50 to 75 basis points. After last week's 25 basis point cut, the rate remains in the range of 4.25% to 4.5%.

Harmark is just one of six Federal Reserve officials estimating that the Federal Reserve is nearing the neutral interest rate.

A larger group of eight officials – which may include Federal Reserve Chairman Powell – believes the neutral interest rate is much lower, possibly around 3% or less.

Powell's key ally, New York Fed President Williams stated, "I don't believe we have reached the long-term neutral interest rate yet. Perhaps the neutral rate is slightly higher than we previously thought, but still far below our current levels."

If he is correct, the Federal Reserve may ultimately need to significantly lower interest rates.

A third, smaller group believes there is more room for rate cuts.

The road ahead.

Of course, which of the three groups prevails will depend on the extent of inflation slowdown next year. If the recent rise in inflation proves to be temporary, the Federal Reserve might increase the number of rate cuts to three or more by 2025.

"Interest rates may still fall significantly in the next 12 to 18 months," Chicago Fed President Goolsbee insisted last week.

Another factor behind Goolsbee and others pushing for lower rates is that some Federal Reserve officials who supported last week's rate cut are more concerned about the weak U.S. job market and its impact on the economy than about inflation.

Even if inflation remains at a certain high level, they tend to prefer cutting rates faster to ensure the current economic expansion is maintained.

The President of the San Francisco Federal Reserve, Daly, stated last week, "What I hear more than you might imagine is that allowing the inflation rate to drop by a tenth should not harm the economy. I do not want to see the unemployment rate rise just to achieve the 2% target a quarter early."

Powell faces the challenge of bridging these divides within the Federal Reserve against the backdrop of Trump's second term as President of the USA, as he had harshly criticized this Federal Reserve Chairman during his first term. Therefore, this will not be an easy task.

However, do not expect any significant initiatives in the coming year. The debates within the Federal Reserve are typically polite affairs rather than heated intellectual arguments.

Powell also enjoys broad support within the Federal Reserve, and instances of opposition are rare, let alone provoking multiple dissenting opinions.

The last Federal Reserve Chairman to lose a crucial vote was Paul Volcker in the 1980s, during one of the most tumultuous times in the economic history of the USA.

Editor/ping